Don’t Get A Surprise Tax Bill From Your IRA

What to Watch Out For In IRA Investments

Don’t Get A Surprise Tax Bill From Your IRA
February 25, 2016

You probably know about potential IRA tax traps related to withdrawals, rollovers, and estate planning that can saddle you with penalties and surprise tax bills. Did you know that the type of investments you hold could also hand you a surprise tax bill and potentially ruin your IRA status?

The most common of the traps results in tax bills through Unrelated Business Taxable Income (UBTI). The sources of business income from stocks, bonds, and funds such as interest income, capital gains and dividends are exempt from UBTI and the corresponding tax (unsurprisingly called the Unrelated Business Income Tax or UBIT). IRAs that operate a business, have certain types of rental income, or receive income through certain partnerships, are subject to taxation once the total UTBI exceeds $1,000. The purpose is to prevent tax-exempt entities from gaining an unfair advantage on regularly taxed business entities.

UBIT can take quite a bite out of an IRA. The top tax rate of 39.6% kicks in at approximately $12,000 of taxable income. These tax bills frequently come with penalties because IRA owners are not even aware that the bill exists.

Master Limited Partnerships (MLPs) held within IRAs are a prime example of how UBTI can catch investors by surprise. MLPs are fairly popular investment vehicles, but when they are held within an IRA, they are subject to UBIT. When the tax is due, the IRA custodian must obtain a special tax ID number and file Form 990-T to report the income to the IRS.

The owner is responsible for paying the tax, and is normally unaware of the bill until it arrives as a completed form to be submitted to the IRS — filled out, and signed on behalf of the owner. In some cases, the owner might be required to pay estimated taxes throughout the year as with self-employment income, thus racking up significant underpayment penalties through ignorance of the rules.

Investment Tax Surprises

Among IRA holders who hold investments subject to UBIT, those who get the surprise tax bills may be the lucky ones. Others remain unaware of the tax dangers to come. A recent Wall Street Journal article reported that IRA custodians sometimes do not have sufficient or timely information on K-1 forms from MLPs to fill out their tax return. This happened with around 5,000 late filings from a Kinder Morgan MLP. In other cases, IRA custodians are reportedly unaware of the entire issue. Eventually a tax bill will arrive, with penalties aplenty.

Engaging in prohibited investments will also result in a tax surprise. Competent advisors will steer clear of these, but self-directed IRAs can easily run afoul of the rules. Alternative investments such as artwork, antiques, and precious metals (with a few exceptions) are generally considered as distributions to you and thus subject to taxes.

Prohibited transactions are a step beyond prohibited investments. They can result in the loss of tax-deferred status for your entire IRA. Examples include using your IRA as security to obtain a loan, using IRA funds to purchase personal property, or paying yourself an unreasonable compensation for managing your own self-directed IRA. Executing a prohibited transaction results in the entire IRA being treated as a taxable distribution to you.

The moral of the story is very clear — as with fund holdings, ETFs, and other investments, it pays to know the details of what you own and how to handle the corresponding paperwork. Seek advisors and IRA custodians who are completely versed in the tax laws and can eliminate any nasty surprises.

Let the free MoneyTips Retirement Planner help you calculate when you can retire without jeopardizing your lifestyle.


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Steffanie | 02.25.16 @ 20:02
I didn't know about all of those. Thanks for the tips. Will definitely be keeping them in mind.
Sara | 02.25.16 @ 20:02
I always pay close attention to every detail I do. However these are some good tips at what to remember.
Nancy | 02.25.16 @ 20:04
Another good reason to have a competent financial adviser. Good to know for the future.
Erin | 02.25.16 @ 20:04
I will be bringing this up before we finalize our taxes. Great information to have and hopefully it will save us some money.
Carla Truett | 02.25.16 @ 20:04
This will be a topic I will discuss with our accountant. I sure don't want any surprises.
Christina | 02.25.16 @ 20:06
Great tips to keep in mind - we have to watch every single detail so closely!
Sarah | 02.25.16 @ 20:06
Always read the fine print with a fine tooth comb - saves lots of headaches in the long run!
Irene | 02.25.16 @ 20:07
Great info, I was not aware of some of this at all but we have never taken money from our IRA yet
Leslie | 02.25.16 @ 20:11
Things like this is why we need a less complicated tax code. It doesn't seem fair that even using a professional a person could still have to pay more taxes on their IRAs. Hopefully the great tips in this article will save someone a nasty tax surprise.
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